Bank Loan Funds: A Great Fixed Income Investment As Interest Rates Rise

When
interest rates rise, fixed income investments, like bonds, decrease in value,
or so the theory goes. However, rising
interest rates do not always mean losses for all fixed income investments. Bank loan funds, also known as prime rate
funds, are an exception to the rule. In
fact, they can even be labeled as alternative fixed income investments.

How They
Are Constructed:

A bank
loan mutual fund invests in senior-secured floating-rate bank loans that are
based on Prime Rate or Libor (also known as the London Interbank Offer Rate - a
kind of international prime rate). The
rate the borrower usually pays is typically a few percent more than the Prime
Rate or Libor. The loans are created
when banks lend money to corporations to purchase large amounts of equipment or
to build new facilities. Many banks
sell the loans, mainly to mutual funds and other institutional investors, while
others hold them in their own accounts.

Interest-rate
fluctuations are another reason to consider bank loan funds. Bank loans don’t increase or decrease in
value inversely to movements in interest rates in a significant manner, as bonds
do. This is due to bank loan interest
rates resetting themselves within 60 to 90 days after interest rates
change. However, when interest rates
are increasing, the loans will slightly increase in value (the opposite of
bonds), and vice versa; therefore, it is possible to increase or decrease in
value.

Credit And
Liquidity Risks:

Bank loan
funds have little or no correlation with any asset class and can be a good
hedge against declining stock prices and inflation. However, the credit and liquidity risk on these vehicles are a
consideration that should not be overlooked.

One risk
is that banks may lend to companies who are poor credit risks. This means the borrowing companies could
default on the loan, which could eventually become worthless. In addition, most of these loans are not
monitored by credit agencies since the lending banks provide the credit
analysis. This risk is somewhat
mitigated by the fact that most bank loan funds only buy senior-secured loans,
meaning in the event of a liquidation, they are pledged against the physical
assets that were purchased or constructed, which should provide ample
protection in most situations.
Furthermore, bank loans purchased by bank loan funds have a very good
history with very few defaults occurring, to date.

Also,
credit risk is significantly reduced with the knowledge that the secured assets
can be sold to pay off the loan. Bank
loans are higher in a company’s capital structure than are bonds, so they will
be paid-off first. In fact, when loans have
defaulted, frequently the fund receives stock of the defaulting company, which
often rises in value when the company comes out of bankruptcy thereby allowing
the fund to receive a greater principal value than the loan itself. However, this type of event is not a
panacea. Many companies do not come out
of bankruptcy and it may take a few years for the fund to receive its money
from the pledged assets when they are liquidated. Another added safeguard is the fact that portfolio managers of
bank loan funds perform their own credit analysis of all loans before
purchasing them.

The market
for bank loans is relatively small.
Therefore, these loans are not very liquid. Consequently, access to one’s money is not immediate. Most funds allow redemptions only once per
quarter or once per month, depending on the fund. This is actually a positive because investor monies will not be
redeemed from the fund all at once.

Another
liquidity problem concerns pricing.
The Securities and Exchange Commission strongly encourages bank loan
funds to utilize outside pricing services.
These pricing services estimate the value of each loan on a daily
basis. Bond funds frequently use pricing
services as well to price infrequently traded bonds such as municipals. The good news is that trading volume has
increased on bank loans. This with the
utilization of pricing services has made bank loan funds significantly more
viable investments and liquid.

Alternative
Fixed Income Investments:

Bank loan
funds can be considered an alternative Fixed Income Investment since they make
money when bonds don’t. As interest
rates increase, these funds are an even more valuable part of any
portfolio. Unlike many of its
fixed-income counterparts, bank loan funds have performed well in 2003 and
especially since July when interest rates began to rise. We believe these investments will become
significantly more popular in the next few years as interest rates rise.

For
further information, contact Louis P. Stanasolovich, CFP™ at (412)
635-9210 or e-mail him at legend@legend-financial.com.